Second Bi-Monthly Monetary Policy Statement on June 2 , 2015 by Governor Rajan: RBI reluctantly reduces the repo rate even as it raises its forecast for inflation !

RBI Watch                                                                                    Monetary Policy 2015-16

Governor Rajan announced a 0.25% cut in the repo rate to 7.25%. No changes were made in the Statutory Liquidity Ratio and Cash Reserve Ratio.

RBI sees inflation rising to 6% by January 2016, slightly higher than the 5.8% forecast in its last bimonthly policy statement. A key factor in raising the forecast is the good possibility of a below normal south-west monsoon. Given its explicit mandate to reach a targeted level of inflation (please see my blog of March 10, 2015), I would have thought that the RBI would have kept the repo rate unchanged. Yet, it has chosen to reduce the rate.

Rajan has justified this on the ground that the economy continues to be weak - both on the supply side and demand side. Hence RBI's forecast for Gross Value Added for 2015-16 has been reduced from 7.8% to 7.6%. This then is the basis for the cut in repo rate.

It seems that the RBI has reluctantly bowed to pressure from the government and industry. This time RBI has some room to soak up the pressure.

I believe another reason to reduce the repo rate is to force banks to make further cuts in the base lending rate, i.e. the  benchmark minimum rate at which banks lend to their customers. Since the RBI's move, a few public sector banks have responded by reducing the base rate.

Given that there is no change in RBI's forecasted path of inflation till the end of the year - a fall to 4% and then a rise to about 6% by the end of the year - I believe that the RBI will not make further cuts in the repo rate till the end of the year. If inflation overshoots to the downside to below 4%, then a rate cut would be warranted.

Please read also my blog of May 30 to get the full picture.